DQ Entertainment – part of India’s outsourcing phenomenon

When you read about the growth of the Indian economy and the country’s huge economic, as well as cultural potential you tend to think in terms of more Pepsi cans sold, higher sales volumes of cars or mobile phones or computers etc. But you do not immediately think animation studios, do you? Yet this is one of the market segments that is developing on a pretty sure footing in India, helped by the outsourcing phenomenon, which the reader without a doubt observed in India’s IT sector.  

With the rise in multi channel TV and ever growing sophistication of computer games, the animation industry is expected to double in turnover in India by 2013, to be worth some $790m (helped by entire media and entertainment industry’s annual expansion rate of some 12%). The animation production segment is expected to grow the fastest. The industry’s current major players in India include Maya Entertainment, Tata Visual Computing Labs, Toonz Animation and Avitel.

However, the company that really sticks out is Asia’s leading animation production outfit – the EMMY award winning DQ Entertainment PLC (has over 90 international partners). Based in Hyderabad, the ISO-9001 certified studio has 3500 employees and over 300 freelancers churning out top class work. When the company listed in London in December of 2007 (LSE: DQE), it was a mere service production studio for outsourced work. It is now moving into co-production (clients include The BBC, Discovery Kids and France 2) and therefore co-ownership of IP rights. DQ’s business model these days includes animation solutions for pre-production, production and development, post production work, distribution, licensing and even merchandising.

As a result of the transformation of the business model, DQ (currently capitalised at £39.6m) has been able to double its EBITDA margin (from 21% to 43%). With the share price trajectory on the up for the majority of the last year and the mainly positive news flow coming from the company, investors seem to give their thumbs up judging by the posts on main internet discussion forums.

DQ has three business divisions: animation (high-end design and production of animation effects for films), gaming (complete animation solutions for online/mobile game development) and new media division (licensing and distribution). The company’s strategy of low risk approach to only enter into co-production with high profile partners of iconic brands seems to be working well. DQ sales team has done a great job and locked in clients such as ZDF of Germany, Moonscoop of France and Disney Australia (deal for co-production of Jungle Book) and NBC Universal (deal for Jungle Book distribution in several European countries, Australia and Japan).

Balkand, Ravan and Omkar properties are also to be launched in 2010-2011 and co-development of Lassie (EMMY award winning series) is to go ahead in partnership with Classic Media of UK and ZDF of Germany. An exclusive broadcasting deal has also been executed with Turner Entertainment Network Asia for animated Iron Man broadcast across all of Asia in 2010.

DQ’s capital base is made up of $46.5m worth of equity and $7.1m worth of debt ($786k of this being current). Debt to Capital ratio is therefore just over 13%.

Annual revenue for 2009 came in at $32.2m ($24.1m in 2008), a 33.6% growth (revenue from distribution almost doubled). The gross margin increased from 26.9% of revenue in 2008 to 35.3% of revenue in 2009. Despite such strong headline acceleration, the EPS for the year 2009 came in at 12 cents (60 cents in 2008). The results are based on 11.9 million shares outstanding in 2008 and 35.9 million in 2009. Net income was further dented by doubling of distribution expenses, 48% growth in admin expenses, more than doubling of financial expense due to foreign exchange losses and a one-off income of $4m recognised in 2008 for extinguishment of liability on preference share capital and convertible debentures. $4.4m annual income in financial 2009 gives us a return on capital of 8.2%.

Total assets at end of financial 2009 were $59.9m ($70.6m in previous comparable period). The reduction is due to a) lower property, plant and equipment values b) a reduction in value of distribution rights and c) lower cash balances ($5.9m at end of financial 2009 and $17.5m at end of financial 2008). Total liabilities of $13m were lower at end of financial 2009 compared to $16.9m at end of financial 2008. The main cause was a reduction in long term debt. Liquidity is good at Current Ratio of 1.7; however it has deteriorated on 2008 when the ratio was 2.98.

Cash from operating activities for financial 2009 came in at $1.6m ($3m in 2008). Lower income and working capital movement made up the result. CapEx in financial 2009 came to $5m and the company paid no dividend.

Assuming DQ manages to generate enough cash to earn its cost of capital (ROC needs to be around 15%), the company will increase its value. For now the share quote of 110 pence seems to reflect the business fundamentals fairly accurately.

Considering the expected fast growth in merchandising (due to emergence of organised retail in India) and over 400 hours of catalogue with IP rights (valuable on-going revenue stream), DQ has plenty of scope to build itself up in Asia and beyond.

With relatively tight ownership - 20% of equity held by Bank of New York and 13% of equity held by the CEO - and $92.5m order book the company has the attributes investors like. The downside of a smaller float is however lower share liquidity that seems to be an issue for some investors. This may improve after DQ lists in India (on 30th September filed an application with Securities Exchange Board of India).